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AGNC Investment Corp.: Bond Investors, It's Worth The Risk

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About: AGNC Investment Corp. (AGNC)
by: Gary J. Gordon
Summary

Bond investing is a miserable venture these days, with low to no yields globally.

AGNC Investment, a REIT that invests in agency mortgage-backed securities using leverage, has a huge 11% dividend yield.  Is it worth the risk?

I briefly review AGNC's interest rate risks and conclude that the REIT is managing them well and results should be stable ahead.

I therefore believe that it is worth the risk to add AGNC to a fixed-income portfolio.

Bond investing really sucks these days. Yields are pathetically low around the globe, with nearly 20% of the Earth’s government debt requiring you to pay. In our own benighted USA, handing over your hard-earned (or ill-gotten, I don’t judge) money to Uncle Sam for ten years gets you a paltry 1.86% a year. After tax, barely enough to keep up with inflation.

And there sits AGNC Investment Corp. (AGNC) with its juicy 11% dividend yield. AGNC generates this yield by investing in agency (Fannie Mae and Freddie) mortgage-backed securities (MBS) and financing about 90% of them with “repo” debt, which is short-term bank borrowings collateralized by the MBS. It then hedges the repos to create debt with closer durations to the MBS.

My abacus tells me that AGNC’s 11% yield beats the heck out of government debt. Now, when investments seem too good to be true, the battle-hardened investor has learned to stay away. An 11% yield almost certainly comes with significant risks. And AGNC certain has risks, as I will (briefly, I promise) detail. The right question to ask is whether the return justifies the risks. I believe it does. I believed it on May 22 of this year, when I first wrote about this REIT ("AGNC Investment Corp.: A Dividend Play Whose Time Has Come"). I still believe it.

AGNC’s interest rate risks…

My main investment plays I’ve been writing obsessively about are the mortgage insurance companies (MGIC Investment Corp. (MTG), Radian Group (RDN), Essent Group (ESNT) and National Mortgage). They are home mortgage credit risks. AGNC has de minimis credit risk - its MBS are home mortgages insured against default by Fannie Mae and Freddie Mac. But owning agency MBS subjects AGNC to a variety of interest rate risks:

Prepayment risk. AGNC, like other agency MBS investors, generally has to buy above par, largely in order to pay mortgage originators and servicers and Fannie/Freddie. As of the end of Q3, AGNC’s agency MBS were on its books for 103.2. Homeowners only pay back 100, so AGNC must write down (amortize) the extra 3.2 over the lives of the loans. If the loans pay down over five years, that’s an average amortization of 54 bp per year. If they pay off over three years because interest rates fall and homeowners more actively refinance, the annual charge hits 107 bp, or about half of their expected interest margin.

Extension risk. This is the opposite of prepayment risk. What if interest rates rise and few homeowners are incented to refinance? Let’s say that the duration of the MBS stretches out to ten years. The good news is that the amortization charge drops to 32 bp a year. The bad news is that the duration of AGNC’s debt that finances the bulk of these loans is only three years. So, AGNC would have to refinance that debt at higher interest rates, again reducing the interest margin.

Thus, the REIT must hedge against both rising and falling interest rates. That’s hard. But wait – it gets worse.

Yield curve risk. AGNC’s MBS have roughly five-year average lives, and its repos only three-month average lives. It therefore hedges the debt, but let’s leave that aside for the moment. The yield curve between five years and three months thus has a material impact on its earnings, as this chart shows:

Source: Company report, Federal Reserve

Basis risk. AGNC’s repo funding is supposed to trade closely to Fed funds and other short-term bank rates. But look what happened to repo rates this year:

Source: Company report

That widening spread increased AGNC’s borrowing costs.

... And the market’s central bank risks.

The interest rate risks described above are hard enough to manage. But now AGNC has to wrestle with dramatic Fed behavior. To avoid a fascinating but lengthy economic discussion, here’s the problem in bullet points:

  • The world has built up massive amounts of debt over the past two decades. The Bank for International Settlements estimates that global debt as a percent of global GDP rose from 191% in 2001 to about 240% today.
  • Financing that debt has become a serious problem, as evidenced by the ’07-’08 financial crisis.
  • Central banks globally have felt obliged to help manage the debt burden by keeping interest rates low. Hence, negative Fed funds in Europe and Japan and huge pressure to lower Fed funds in the U.S.
  • Central banks took further and unprecedented steps to manage long-term interest rates by buying long-term government and even corporate debt, a process called quantitative easing.

In 2003, the U.S., European and Japanese banks held $2.5 trillion of assets. Today, that number is $13 trillion. I’ll bet that number doubles over the next decade, but that’s another story.

So what’s a poor mortgage REIT to do? AGNC’s surprisingly good Q3 gives clues.

Last week, AGNC reported operating EPS of $0.59, well above the $0.49 forecast. On its Q3 conference call, management summarized the good news as “AGNC’s strong financial results can be attributed to both the optimization of our specific MBS holdings and the significant repositioning of our hedge portfolio... We currently believe that the majority of the improvements in our net spread and dollar roll income in Q3 should be sustainable over the near-term.” Here’s the specific good news:

  • Prepayment risk. AGNC has, for many years, focused on buying MBS with a lower propensity to prepay - smaller balance loans and “HARP” loans, which originally originated during the housing bubble. As a result, AGNC’s loan repayment rates have, for many years, been lower than Fannie Mae’s by 20% or more. Last quarter was no different.
  • Extension risk. At present, AGNC has hedged 101% of its short-term borrowings, turning three-month debt into three-year debt. Also, given the global debt problem I described above, it seems highly unlikely that central banks will allow interest rates to rise much.
  • Yield curve risk. Not much that AGNC can do here. But the yield curve is already inverted, and the Fed has begun easing, so the problem is likely to ease going forward.
  • Basis risk. As AGNC noted, “The disruptions in the repo market being so pronounced and so public turned out to be a catalyst for the Fed to act... In mid-October, the Fed announced its plan to purchase approximately $60 billion of treasury bills per month for at least six months... These actions could add more than $500 billion of liquidity to the system over the next six months. As such, we are optimistic that the repo headwinds that we faced throughout 2019 will soon abate.”

In sum, AGNC is managing its prepayment and extension risks well, and the Federal Reserve is working to alleviate some of the mortgage REIT’s yield curve and basis risks.

This 11% yielding stock should hold or even improve its value over the next year.

Wall Street analysts expect AGNC to earn $2.12 per share next year, following a $2.08 forecast for ’19. I believe those are reasonable estimates considering the likely improving risk dynamics noted above. If so, AGNC can, of course, maintain its current 11% dividend yield, which should keep the stock at least stable and possibly nudge the price up a bit.

So, mixing a little AGNC into your bond portfolio should be a good thing. And you like good things, don’t you?

Disclosure: I am/we are long AGNC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.